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Google is close to sealing a significant victory in its escalating battle with Microsoft after reaching an unofficial agreement to ally itself more closely with AOL, including paying $1bn for a 5 per cent stake in the Time Warner internet services division.

The alliance, which includes the broadening of an existing advertising relationship with AOL, could also reinforce the position of Dick Parsons, Time Warner’s chairman, who has been under pressure to prove that he can squeeze more value out of the group’s sprawling media holdings.

By reaching a new five-year agreement, at least in principle, to supply search results and related advertising to AOL, Google has frozen out Microsoft’s attempt to secure an AOL alliance of its own as a way to kick-start its own rival search service. “It is a big blow – [Microsoft] hoped this would put them on the map,” said Charlene Li, an analyst at Forrester Research.

Mr Parsons is expected to seek approval for the proposed deal at a board meeting on Tuesday, with details to be finalissed over the weekend, according to people close to the situation. The move will give AOL an implied value of $20bn, double the value accorded to AOL in Time Warner’s current share price, analysts say.

A deal with Google may aid Mr Parsons in his battle with Carl Icahn, the activist shareholder who controls around 3 per cent of Time Warner, over the future direction of the company. Mr Icahn is preparing an ambitious proxy fight to demand radical measures, such a break-up of its different units, that he believes would unlock shareholder value.

The internet group, which acquired Time Warner at the height of the internet bubble six years ago in what is widely regarded as one of the worst corporate mergers, has recently re-invented itself as a free portal in an effort to gain internet advertising market share. Until then, its business model was based around subscription revenues, and AOL lost ground to Google and Yahoo as internet advertising soared.

AOL’s selection of Google is a setback for Microsoft’s plans to boost its MSN service. Microsoft has been in talks with Time Warner over an AOL deal for most of this year, and had hoped to use search traffic from AOL users to help boost a planned online advertising network that it plans to launch in competition with Google and Yahoo! However, choosing MSN over Google would have been a risk for AOL, given the unproven nature of MSN’s advertising service, said Ms Li.

Under its current relationship with Google, AOL receives 80 per cent of the revenues from search-related advertising that Google displays on AOL websites. Under the proposed new deal, AOL will also be able to sell search ads alongside Google’s, plugging a gap in its offerings to advertisers. In addition, AOL will sell display ads on both the AOL and Google internet properties. The deal also includes the promotion of AOL content through Google’s paid search and the two companies will jointly develop video search capabilities.

Time Warner shares rose less than one percentage point to $18.00. Investor enthusiasm for the Google tie-up would be likely to make Mr Icahn’s task more difficult. Mr Parsons has identified AOL as the key to Time Warner’s future value.